Bitcoin will prosper — until governments or banks decide to crush it overnight

Bitcoin

Every currency created since the advent of money 2,700 years ago has fit nicely into one of two classifications: Either it was a representative money system, deriving its worth from a link to some physical store of value like gold, silver or gemstones; or it was fiat, deriving its value from the fact that a government or central authority guaranteed it.

Bitcoin, the world’s most successful digital currency, defies this time-tested classification system: It is neither fiat nor representative. It is not fiat, because its supply is actually finite and, more importantly, it lacks any central backing authority. (Click here for a good primer on the tech behind Bitcoin). Nor is it representative, because it is not linked to anything physical. Thus the internet has (once again) spawned a phenomenon that is inexplicable via conventional economic frameworks.

As economists study the attributes of digital money, they are discovering that Bitcoin is, in many ways, a better currency: unlike paper money, it is unforgeable; unlike gold, its supply is perfectly verifiable. It is immune to the inflation that plagues all fiat currencies: governments cannot simply print Bitcoins to pay off their debts. It is perfectly secure: all transactions are monitored collectively by the Bitcoin network. Bitcoin payments can be made at any time, to anyone, with as little as zero fees and no dependence on financial intermediaries. Bitcoin transaction histories are distributed and decentralized, making the system robust and resilient. And Bitcoin minimizes the amount of personal information that users have to disclose when transacting.

For all of these traits, Bitcoin has potent disruptive potential to the world banking system, and thus the governments that are supported by it. Which is precisely why it is doomed.

Anonymity threatens control

Though novel today, the anonymity of transactions that Bitcoin provides is actually a very old trait of money, one that most currencies actually enjoyed for most of their history. If fact, it was only recently eradicated by virtue of the digital nature of modern banking, combined with legislative initiatives in the United States (and other countries).

Governments today enjoy unprecedented power of monetary observation, which they argue has resulted in a “safer” world with less money laundering, greater impediments to criminal activity, and reduced tax evasion. Industrialized nations are just beginning to maximize the benefits of this newfound transparency and so understandably have no interest in reverting to a more opaque banking system.

Monetary control is power

But beyond monitoring money flow, there is an even more fundamental reason why substantial Bitcoin success is undesirable for governments. For any government, ceding control of money supply is tantamount to an abdication; without control of money there is no control at all. For this reason, as Bitcoin continues to gain users, government indifference must gradually give way to bemusement and ultimately resistance.

However, well before governments attempt to curtail Bitcoin, there is another antagonist that might take action more rapidly: the financial services industry. Banks and their kin make tens of billions of dollars every year from providing the very basic task service of moving money from one place to another. And as a nearly foolproof revenue stream – zero risk, almost zero cost, and billions of dollars in profits – it’s also a pillar of their business model. In fact, banking as we know it today would have a far diminished role, if any, in a Bitcoin-denominated economy. Hence, you will see little support for digital money from any bank.

Thus, if Bitcoin can continue to gain in popularity, its users can look forward to an eventual confrontation with two extremely powerful antagonists. Unfortunately for Bitcoin, both parties, governments especially, can follow a simple strategy to ensure Bitcoin, or any other aspirational digital currency, never gains widespread use.

Governments hold nuclear option

The strategy, by the way, is not prohibition. A legislative attempt to curtail Bitcoin would be hampered by political agendas, court challenges, enforcement costs and, perhaps most importantly, the complications national boundaries create. Indeed, lawmaking is utterly clumsy compared to the much cleaner, cheaper and perfectly effective solution called “currency intervention.”

All major economic powers are experienced in the techniques of manipulating the value of monies whose price they care about. To affect a currency, one need simply to buy or sell enough of it that marginal supply or demand is affected. Price change then follows naturally. (For example, China and Japan have done this in the recent past to weaken the buying power of Renmimbi and Yen respectively, to reduce the cost of their exports in Western markets.)

Interventions are usually meant to do one of two things: change the value of a currency or moderate the volatility of a currency. But currency intervention can just as easily be used to increase the volatility of a currency. And, in the case of Bitcoin, it would be utterly simple to do because the total value of all Bitcoins, currently about $1 billion, is so minuscule compared to the buying power of any industrialized country.

This would remain the case if Bitcoin’s market cap increased 100-fold or even 1000-fold. The algorithm is simple: gradually purchase large sums of Bitcoins, a  hundred million dollars worth given the current market cap would be plenty. Then flash sell them to flood the market and drive the price down. Rinse, repeat.

A currency that quintuples in a month, and then loses two-thirds of its value in the following week, is not a currency that inspires confidence in users. And while features like security, verifiability, untamperablity and decentralization are attractive, they are all secondary to the main factor that controls adoption of any currency: stability of purchasing power.

Thus Bitcoin’s Achilles heel is its susceptibility to manipulation by the very people who need Bitcoin to fail. It seems not just possible, but likely, that the potential victims of Bitcoin would exploit this vulnerability if they needed to. And, ironically, they would be able to do this totally anonymously. It is this vulnerability that the Winklevosses and others who are “going long” Bitcoin should probably take a good look at sooner rather than later.

Tammer Kamel is founder and CEO of Quandl, a searchable database of numerical data, including a collection of Bitcoin statistics. Follow him on Twitter @TEKamel.

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